What will it take for finance workers to report wrongdoing?

Turning a blind eye to the wrongdoing of colleagues has become the norm at many financial services firms. Despite the MF Global debacle, the rogue traders at UBS and Societe Generale, the subprime mortgage mess, and Goldman Sachs’ tarnished reputation, most corporate employees continue to withhold information about misconduct by colleagues on issues they know are wrong, until it turns into a major financial imbroglio, according to a recent study.

In fact, employees do not report 50% of observed misconduct. And even when unethical behavior is reported, 60% of managers said they’d only divulge information to a senior executive if the impact of the case exceeded $1 million, according to a 2011 study of 500,000 employees at 150 companies (many, but not all, financial services firms) over four years, conducted by Corporate Executive Board, an Arlington, Va.-based consulting firm.

The improper conduct goes unreported because people “fear retaliatory action, including losing their job, failing to get promoted, failing to get a bonus,” explains Thomas Monahan, chairman and CEO of Corporate Executive Board. Many employees expect that the misconduct will be buried under the table and no action will be taken. Indeed, companies have failed to create a healthy, ethical culture where people feel “they will not be retaliated against and the company will go and do something” about the wrongdoing, Monahan suggests.

When illegal practices go unreported at a financial services firm, the stakes are high. Firms face significant fines and legal costs, reputation damage, and tightened regulatory scrutiny. Fines of $100 million have been leveled against companies that have defied the U.S. Foreign Corrupt Practices Act, says Monahan.

Why would it take a one million dollar loss to influence staff to blow the whistle on an illegal practice? Monahan says, “People need to be highly convinced that this is a potential catastrophe to take the risk.” Otherwise, they’ll stay mum and avoid the threat to their career stability.

Managers are no different from employees, often choosing to squelch rather than report illegal incidents. They also fear retaliation and being blamed, justifiably or not, for the wrongdoing. “Will I be a pariah if I bring these issues to bare?” they wonder, Monahan argues.

“The most important thing companies can focus on is, ‘How do you make it okay for someone to feel comfortable sharing negative information?’” Monahan notes.

For companies to change their culture and encourage wrongdoing to surface, Monahan says leaders must communicate “preemptively” to let staff know that unethical actions are going to happen at times, but if they surface these issues they will be protected. He says they should also describe what action was taken to resolve any ethical lapses and spread the word. Monahan also argues that managers need to penalize or dismiss employees that commit unethical acts.

Corporate Executive Board has come up with an “Integrity Capital” scale, which rates companies based on six components, including clarity of expectations, encouraging staff to speak up, trust in colleagues, direct manager’s leadership, openness of communication, and tone at the top. Royal Bank of Canada (RBC) scored in the top quartile on these rankings. Ironically, on April 3, 2012, the Commodity Futures Trading Commission accused the RBC (RY) of fabricating bogus trades to generate ample tax benefits. RBC has denied the charges and all wrongdoing.

How could RBC staff have allegedly committed these acts despite creating an atmosphere of strong integrity? Monahan says an organization’s culture can establish norms and regulate behavior, but it’s not a perfect system. “Culture often fails to drive the behaviors of rogue employees’ intent on breaking the rules,” he says. RBC declined to offer comment for this story.

Roy Smith, who teaches ethics at NYU’s Stern School of Business and was a former general partner at Goldman Sachs (gs) from 1966 to 1987, says that most of the scandals have taken place at the major financial services firms that do risky trading, not at regional banks that generally avoid exotic financial products like derivatives. The nature of trading, which involves the assumption of risk and betting on financial instruments, doesn’t fit easily into a simple ethical code. While most trades are legal, a certain percentage of traders will take shortcuts and try to get an edge on a deal and may overstep ethical boundaries

When a financial firm’s compliance staff warns traders about going too far or skirting the edge of what’s legal, a trader’s typical response is, “‘Don’t tell me what I can’t do. Tell me how to do it,’” Smith says. Traders have a fiduciary responsibility to their customers, but they are always looking to gain the upper hand on their trading partners, and that can turn into evading the rules.

For all trades to be vetted properly, Smith says, “You’d need one group of people [traders] using the accelerator and legal and compliance using the brake.” Following every ethical rule and nuance would lead to firms cancelling, limiting, and restricting traders, and that’s not likely to happen.

Smith says his ethics class doesn’t focus on teaching morals, which he says wouldn’t be effective, but instead concentrates on looking at ethics as a leadership issue. “If you work at a company and don’t impose standards on those who work there, you’ll have anarchy and no standards,” he says.

Since money often talks louder than ethics training, making it a part of compensation makes sense. Perhaps people have to be rewarded for citing wrongdoing. “Companies reward people for risk adjusted profit,” Monahan notes. After all, he says, speaking up against wrongdoing helps the bottom-line in the long run.

Editor’s note: A previous version of this story incorrectly stated Thomas Monahan’s title. He is the chairman and CEO of Corporate Executive Board. A previous version of this story also incorrectly stated that the Royal Bank of Canada received the top score in a recent integrity ranking by the Corporate Executive Board. RBC scored in the top quartile instead.

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